Money & Banking

Will the bad bank appeal to everybody’s palate?

New Delhi | Updated on March 01, 2021

For it to take wings, design issues must be sorted out – the final structure holds key for it to succeed in a mixed economy like India

It’s almost a month since the Budget was announced. If there is one proposal in the Budget that could truly have a transformative effect on the Indian banking sector, it is the one on the setting up of an Asset Reconstruction Company (ARC) along with an Asset Management Company (AMC) to take over the stressed debt of banks.

No clarity yet

Even though there is no clarity on the final design of this proposal (loosely called bad bank by hacks and certain banking industry observers), one thing is for sure – the sooner the government goes about finalising the structure, the better it will be for the economy.

Yes, you got it right. There is nothing wicked about a bad bank. It is basically an entity that houses the bad loans (non-performing assets) of a bank. This bad bank will goabout resolving or liquidating bad debt (stressed debt) to recover as much money as it can. The bad bank model was first proposed in the 1980s in the US (Mellon Bank).

Going by the thinking in Department of Financial Services (DFS), one may have to gear up for a ‘Made in India’ model of bad bank that will have to function in an ecosystem where there is no deep debt market to write home about.

Typically, a Bad Bank structure works efficiently when there is a deep debt market, and the number of market participants are wide enough to allow sufficient price discovery and market making.

Structure of bad bank

If one were to infer from the sketchy details available in the public about the proposed structure, one may end up with a solution that may be ill suited from a market economy standpoint, a status that India has been striving to achieve in the recent decades.

So, what is being envisaged is an ARC (let’s call it a proposed national ARC), where the bad debt of banks (public sector banks) will be transferred (not sold at market price) to it at net book value (value of exposure minus the provisions made for such accounts).

So, this will be a bilateral transfer (no auction of NPAs) from banks to the national ARC. What is disappointing is that there will be no real price discovery as the other 28 existing ARCs in the market will not get an opportunity to bid for such bad debts (assets) at the time of transfer. Now, it is another story how the national ARC will handle the assets it has got at net book value.

The question remains as to what will happen when the net book value of an existing debt in the books of a bank is already ‘nil’, and the answer to this is anybody’s guess. Will the ARC be ready to take it at ‘nil’ value and then look to turn it around or realise a higher value? Hopefully, all those private players running billion-dollar-plus stressed assets fund will get a chance to bid for such assets.

But given India’s continental size and huge stress in the banking system (estimated at ₹8-lakh crore), there will be enough and more for all ARC players if the government and the RBI iron out some rigidities in the system, say some ARC representatives.

RBI chief saves the day

For the several existing ARCs (there are 28 already in Indian market), Reserve Bank of India (RBI) Governor Shaktikanta Das’s comments came asmusic to their ears. Das said that the new ARC will not jeopardise the activities of existing players in the space. At an event organised by the Bombay Chamber of Commerce, he noted that there is scope to have one more “strong ARC”. One of the issues that merit attention is the guarantee that the government has started talking about. There is no mention in Finance Minister Nirmala Sitharaman’s Budget speech about the government looking to give guarantees for this ARC-AMC structure to take off. Clarity is needed on what are the guarantees going to be for – will the government guarantee the security receipts that will be issued or the ARC getting at least the value at which the debt was transferred.

One may also wonder why the government should guarantee a transaction that should essentially be a market-determined play? The second issue is that of the capital of the proposed ARC. The most important decision is that the government will not put even a single rupee of equity capital in the proposed ARC. The only question now remains is whether the new ARC will be PSB-controlled or will the private sector be asked to float the ARC (this is unlikely).

So, if PSBs float and infuse capital in the ARC, critics are going to scoff at the move – they would argue that government may as well infuse capital that would be put in a bad bank directly into public sector banks as capital infusion. Now, alternatively, if the bad bank were to be controlled by the private sector, the reluctance of public sector banks to sell loans to a bad bank at a significant hair cut will still prevail.

The fearof 3Cs

Now, Indian policy makers have seemingly found a way to go about this – make public sector banks transfer the bad loans at Net Book Value and shift the responsibility of recovery to the new ARC (capital funded by public sector banks again out of taxpayers money). By this, bankers’ reluctance to part with assets to ARC will not be there as there is no haircut, and also the much-dreaded fear of 3Cs – CVC, CBI and CAG – will not be there when there are no haircuts to face. It’s another thing that the new ARC will have to use the existing regulatory framework of IBC, SARFAESI to make resolutions work or realise recoveries.

Now, with Prime Minister Narendra Modi comforting bankers that his government will stand by their business decisions taken with the right intent, bankers feel that time may be ripe for the Cabinet (fourth C) to back this up with some form of legislative kavach (protection) for their decisions on handling stressed debt through the new ARC.

The bottomline is that the new ARC is a laudable effort to clear the Indian NPA mess (which may get accentuated once the SC gives its final ruling on asset classification standstill). The new ARC may take wings for the country’s benefit once design issues are sorted out and all aspects around its execution are covered.

Published on March 01, 2021

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